Intermediate Financial Management (with Thomson One)

QUESTIONS
• Dividend policy should take account of the information content of dividends
(signaling) and the clientele effect. The information content, or signaling,
effect relates to the fact that investors regard an unexpected dividend change
as a signal of management’s forecast of future earnings. The clientele effect
suggests that a firm will attract investors who like the firm’s dividend payout
policy. Both factors should be considered by firms that are considering a
change in dividend policy.
• In practice, dividend paying firms follow a policy of paying a steadily increasing
dividend. This policy provides investors with stable, dependable income,
and departures from it give investors signals about management’s expectations
for future earnings.
• Most firms use the residual distribution model to set the long-run target distribution
ratio at a level that will permit the firm to meet its equity requirements
with retained earnings.
• Under a stock repurchase plan, a firm buys back some of its outstanding
stock, thereby decreasing the number of shares, but leaving the stock price
unchanged.
• Legal constraints, investment opportunities, availability and cost of funds
from other sources, and taxes are also considered when firms establish dividend
policies.
• A stock split increases the number of shares outstanding. Normally, splits
reduce the price per share in proportion to the increase in shares because splits
merely “divide the pie into smaller slices.” However, firms generally split their
stocks only if (1) the price is quite high and (2) management thinks the future
is bright. Therefore, stock splits are often taken as positive signals and thus
boost stock prices.
• A stock dividend is a dividend paid in additional shares rather than in cash.
Both stock dividends and splits are used to keep stock prices within an “optimal”
trading range.
• A dividend reinvestment plan (DRIP) allows stockholders to have the company
automatically use dividends to purchase additional shares. DRIPs are
popular because they allow stockholders to acquire additional shares without
brokerage fees.
17-1 Define each of the following terms:
a. Optimal distribution policy
b. Dividend irrelevance theory; bird-in-the-hand theory; tax preference theory
c. Information content, or signaling, hypothesis; clientele effect
d. Residual distribution model; extra dividend
e. Declaration date; holder-of-record date; ex-dividend date; payment date
f. Dividend reinvestment plan (DRIP)
g. Stock split; stock dividend; stock repurchase
17-2 How would each of the following changes tend to affect aggregate (that is, the
average for all corporations) payout ratios, other things held constant? Explain
your answers.
a. An increase in the personal income tax rate.
b. A liberalization of depreciation for federal income tax purposes—that is, faster
tax write-offs.
Chapter 17 Distributions to Shareholders: Dividends and Repurchases • 609